Is the U.S. “AAA” Rating at Risk?

Reflecting on the recent events in the U.S. banking system, two questions spring to mind – “how did we get into such a mess?” and “how much worse can it get?” Well, if some of the subtle warnings emanating from the ratings agencies come into play, it could get a lot worse.

U.S. government debt was first rated way back in 1917 and earned the highest rating – the coveted “Triple-A”. This is the only rating the U.S. has ever known but whispered warnings grew to a dull roar earlier this year as several Government Sponsored Enterprises (GSEs) – read Fannie Mae and Fannie Mac – were pointed out as being on the brink of failure with massive infusions of government cash the only tonic available to ward off complete collapse.

The situation first grew critical when the commercial banks turned off the credit taps as the housing bubble burst and it was estimated that by the end of 2007, nearly 90% of all new mortgage financing was being done through the GSEs. As home prices declined and mortgage defaults grew, rating agencies warned that the government would be left holding the bag. Of course, this is exactly what happened and on September 5th of this year President Bush announced that the government would take control of the troubled mortgage lenders. Throw the recent bailout of Bear Sterns and AIG – sorry Lehman Brothers, no cash for you – into the mix and the chatter gets even louder.

The three main ratings firms – Standard and Poor’s (S&P), Moody’s, and Fitch’s – have all assigned the U.S. the highest rating available for a sovereign nation. Very few other countries enjoy such a rating and those with lower ratings find it more difficult – not to mention more costly – to borrow money on the credit markets. Essentially, just as your personal credit rating affects your ability to borrow money, a country’s credit rating also impacts its cost and access to loans. So, given all the turmoil in the credit markets and the U.S. banking system, is this current rating justified?

With national debt exceeding 9.5 trillion and adding an estimated 1.75 billion per day, the U.S. needs to maintain its top credit rating to keep borrowing costs to a minimum. Earlier this month, S&P pointed out how the problems in the U.S. banking system could force the government to prop up failing firms, but despite this noted risk, it opted to maintain the current rating. On September 9th, Moody’s also made mention of the troubles in the banking system but made no change in the rating it has assigned.

While there seems to be no immediate threat of a ratings cut, there is no guarantee that it could not happen in the future and the next year or two will be crucial. Suggestions that more Wall Street carnage is on the way – I’m looking at you Morgan Stanley – and this could be the trigger for such a reassessment.

In what some may feel to be poetic justice or simply a case of bad karma coming home to roost, no one has lost sight of the fact that the ratings agencies themselves contributed to this crisis of investor confidence by handing out an investment grade rating on what was later revealed to be questionable asset-backed securities. In other words, it was their – shall we say unrealistic – ratings on questionable mortgage-backed securities that helped trigger the sub-prime crisis in the first place and which now threatens to downgrade the U.S. sovereign rating.

This rather uncomfortable fact leaves the rating firms in a bit of a pickle – do they try to minimize potential damage by keeping the U.S. rating at triple A even if not warranted? With confidence in the entire banking system plunging and paranoia taking control of the nation’s boardrooms, will anyone trust what they have to say anyhow?